Microsoft's war plan

It isn't a done deal. But Yahoo's days as an independent company are numbered.

(Fortune Magazine) -- When Jerry Yang answered the phone on a rainy Silicon Valley Thursday night in January and heard the hoarse voice of Microsoft's Steve Ballmer on the other end,
it was simply the last in a string of disappointments the Yahoo co-founder has confronted over the past two years.

Microsoft (MSFT, Fortune 500) had already tried to buy Yahoo a year before -- presumably for
billions of dollars more than the $44.6 billion bid Ballmer told Yang about on Jan. 31. Long before Microsoft went public with its offer the next morning, however, it had become
inevitable that Yahoo would have to sell. What's more, through a combination of poor execution, missed opportunities, and strategic snafus, Yahoo brought that inevitability on itself,
a tainted pioneer too small to compete against Google and too weak to resist a generous buyout.

For a million reasons, Yang didn't want to sell the last time Yahoo (YHOO, Fortune 500) and Microsoft talked. And according to people close to him, he
still doesn't. Yahoo is Yang's baby. He nurtured it from birth. Yes, he handed off its stewardship to outsiders, but he always kept a watchful eye from a cube in the executive suite.
In Yang's eyes, and for all of Silicon Valley, Yahoo -- not Google (GOOG, Fortune 500) -- is the iconic company of the web. It signifies everything that
is fun and exciting and goofy about the Internet, exclamation point and all.

At least it used to. But as 2006 dragged into a dismal 2007 for Yahoo, a bid from Redmond became increasingly likely. Yahoo, a major prize for a Goliath that wants to build a web
empire with a major audience, sizable revenues, and a vibrant brand, simply had screwed up too many times. Fortune has learned that in the fall of 2006, Yahoo failed to buy Facebook
for $1 billion - even though Facebook's young CEO, Mark Zuckerberg, already reluctantly agreed to sell to Yahoo.

Shockingly, Yahoo effectively reneged on its offer, say people familiar with the negotiations. In a nasty case of financial "analysis paralysis," former CEO Terry Semel and former
finance chief and current president Sue Decker came back to Facebook with an offer of $850 million-even after they had agreed on the larger number. It gave Zuckerberg the out he
craved.

Late last year Microsoft bought a small stake in Facebook that values the company at $15 billion. Yahoo also botched the acquisition of YouTube, a deal it had in its grasp but that
went instead to Google. And it lost smaller deals as well.

For example, Yahoo looked hard at JotSpot, a startup Google also bought that gives it the technology and people that can be useful in building the type of social-networking
applications that have made Facebook such an early success.

Yahoo declined to comment for this story.

Yahoo's flubs weren't just M&A-related. For years now the company has seemed to miss every major industry shift-even as Google somehow anticipated just about everything.

While Yahoo was enjoying fat sales of graphical display ads, Google was building a multibillion-dollar business out of paid search. When Yahoo focused on big advertisers on its own
sites, Google figured out a brilliant way to sell ads for other web publishers, an innovation Yahoo is only just getting to in earnest this year.

Since taking over the CEO job from Semel last year, Yang hasn't exactly grabbed the reins with vigor. The 39-year-old promised there'd be no sacred cows, and that he'd conduct a
top-to-bottom review of the business within the first 100 days of his taking over last June. But he proceeded to shoot next to no animals, and most certainly nothing sacred.

Yang closed down Yahoo's photo site, for example, given that Yahoo also owns the far more popular Flickr. And he killed Yahoo 360, a social-networking site that had failed to catch
on. The 100 days and then some came and went with little to show. No product innovation. No transformational deals. No management shakeup.

At the Consumer Electronics Show in early January, a listless Yang showed off some me-too products that weren't even ready for consumers to use. Embarrassingly, a beta version of a
new cellphone application wasn't ready during a live demo-leaving industry bigwigs in the audience to enter a web address that didn't work on their BlackBerrys. Promised changes to
Yahoo's popular e-mail program were shown only in a mockup version, with no release date even suggested.

Then came the financial disaster of fourth-quarter results, which showed that several key Yahoo businesses were slowing, and that the company's turnaround would be a 2009 event at the
earliest.

Microsoft was ready to pounce. There are so many ways a Microsoft-Yahoo combination could fail. Integration will be tricky, despite Microsoft's claim that it has already drawn up a
plan to pluck leaders from Yahoo for key roles in the combined Yahoo-MSN.

The companies have vastly different cultures. Yahoo's people, already leaving in droves, are unlikely to stick around without tangible incentives, like retention bonuses or promises
of greater authority.

And yet Microsoft has little choice but to pursue Yahoo. According to people close to him, Yang has decided recently that he wouldn't take the one step that could have immediately
boosted Yahoo's financial fortunes: a deal to allow Google or Microsoft to sell search ads on Yahoo's behalf. Such a move would have strengthened Yahoo's bottom line primarily by
drastically reducing the amount of money Yahoo needs for expensive data centers full of server computers, plus product development and other costs.

Indeed, Microsoft has long understood that Yahoo couldn't last independently because of the sheer expense of competing against Google's server farm expansion. By buying Yahoo,
Microsoft gets a vastly bigger audience to go with its formidable resources.

There's no guarantee Microsoft will get its prize, of course. It seems likely other bidders will at least kick the tires and that Yahoo will demand a higher price. Microsoft knows and
expects this. On Microsoft's conference call with analysts on the morning of the offer, general counsel Brad Smith said that Google won't be able to bid for Yahoo because of antitrust
concerns.

It's ironic that Smith, who has fought Microsoft's antitrust wars for years, would offer such advice. All the same, he's probably right. But just because a Google-Yahoo combination
would meet resistance from regulators doesn't mean Google won't try to be creative.

It could partner with another media company -- a News Corp., for example -- in a move that might deflect antitrust concerns. European telecom giants Vodafone or Nokia could bid for
Yahoo-and pay a hefty premium due to the weakness of the dollar. Longtime Yahoo partner AT&T (T, Fortune 500) also might see a way to come to its friend's rescue. Who knows?
Maybe even a sovereign wealth fund from Asia, where Yang has an extensive network of contacts, could attempt to be Yahoo's white knight.

Based solely on their ownership in Yahoo, about 10% of outstanding shares, Yang and his co-founder, David Filo, can't do much to stop a takeover. Yang's influence in particular, both
with the rank and file and the board of directors, long has exceeded his ownership stake. This is effectively why he's the CEO in the first place and probably why Yahoo headed into
2007 an independent company.

In an interview earlier this year in Las Vegas, I asked Filo if he and Yang ever wished they had emulated the Google co-founders and created a separate class of stock so that their
control or their ability to invest for the long term would have been greater. "That thought comes up a lot," the notoriously soft-spoken Filo replied.

But getting back to the inevitability of it all, at least two things are clear from Microsoft's lightning strike. One, despite the previous courtship from Redmond and a persistent
swirl of rumors that Yahoo was ripe for the taking, the bid clearly caught Yahoo off-guard. Two, these two companies are simply in different leagues as far as overall sophistication
goes.

Microsoft is the seasoned Pro Bowl team to Yahoo's junior varsity squad. Hours before Microsoft launched its bid, Yahoo was busy setting up routine meetings with magazine and
newspaper editorial boards for later in the month. Meantime, according to a source from Microsoft's camp, the software giant's representatives were pushing information on Wall Street
suggesting AOL was in play-all to make sure hedge funds didn't catch wind of a Yahoo bid and drive up the company's stock.

The JV vibe extends to Yahoo's board, which hasn't bathed itself in glory either. It may have been quite correct in dumping Semel, who had clearly outlasted his usefulness.

But rather than recruit an experienced manager, the board chose a universally beloved figure who had never run a small organization, much less a 14,000-person company-and who
proceeded to squander his time and opportunity.

Yahoo will undoubtedly go down swinging. No one who has been around deals expects Yahoo to meekly acquiesce to Microsoft's offer. But for months now Yahoo has appeared clueless,
plodding, and just not that passionately concerned about its own survival.

Last fall Thomas Weisel Partners analyst Christa Sober Quarles ran into Yang at an event at the Asian Art Museum in San Francisco, which Yang and his wife have supported generously.
Quarles asked Yang if Yahoo was going to be able to turn things around. "He said, 'Ya know, I just don't know,' " Quarles recalls. "And that wasn't the answer I wanted to hear. I
wanted to see the will to win." For Yang and Yahoo, having the will to win may now matter less than getting the best price for their shareholders.